The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Tuesday, June 11, 2013

Sheila Bair asks "Does anyone have a clear vision of the desirable financial system of the future"

Since Sheila Bair asked "does anyone have a clear vision of the desirable financial system of the future" and responded by providing a variant of the financial system that collapsed at the beginning of the current financial crisis, I thought I should answer her question.

The number one lesson of the financial crisis is that a financial system that is reliant on complex rules and regulatory oversight is prone to failure.

It is a myth that more complex regulation and regulatory oversight would have prevented the financial crisis that started on August 9, 2007.

The reason it is a myth is that a financial system that relies on complex regulations and regulatory oversight is dependent on the regulators to a) do their jobs, b) properly assess what is happening in the financial system and c) accurately communicate their findings to market participants. Because of concern about the safety and soundness of the financial system, regulators will never accurately communicate their findings.

The financial system of the future is the same financial system that was designed in the 1930s and based on the FDR Framework. This financial system incorporated the philosophy of disclosure with the principle of caveat emptor (buyer beware).

It assigns a very specific role to the financial regulators. They are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Fulfilling this responsibility means the financial regulators have to eliminate opacity in all the large areas of the financial system where it currently exists.

For example, regulators need to require that banks adopt that 1930s standard of disclosing all of their current global exposure details. This includes assets, liabilities and off-balance sheet exposures.

For example, regulators need to require that structured finance securities disclose when an observable event occurs with the underlying collateral, like a payment or delinquency, before the beginning of the next business day.

The FDR Framework also assigns responsibility to the market participants. They are responsible under caveat emptor for all gains and losses on their exposures. Responsibility for losses gives market participants an incentive to independently assess the disclosed information. Market participants use this independent assessment to limit their exposure to what they can afford to lose given the risk of the exposure.

By limiting their exposures to what they can afford to lose, market participants build robustness and resiliency into the financial system and make it so it is not prone to failures.

Unlike Ms. Bair's, my proposed financial system for the future has 6+ decade track record of successful performance.

Ms. Bair's proposed financial system that allows opacity and relies on complex rules and regulatory oversight has already shown that it is prone to failure within a decade.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.